Earnings per share has conventionally been used as a tool for distinguishing the effective cost of debt versus equity.
However, hybrid securities pose a challenge for evaluating earnings per share. For certain financing alternatives, such as convertible bonds and stock options, for example, the impact on earnings and shares outstanding may change over time. A convertible bond, for example, generates tax-deductible interest expense until it is converted into a fixed or variable number of shares. It would seem that for the debt part of its life, a convertible bond reduces earnings; and for the equity part of its life, it increases shares. In an attempt to reconcile this dual nature of hybrid securities, it is believed that the current required accounting treatment is based upon “diluted EPS”, which requires EPS to be calculated as the worse of two alternatives (see SFAS No. 128, paragraphs 11-39):                1) Basic EPS.        2) Same as basic EPS, except (a) the denominator is increased to reflect the potential number of additional shares, and (b) the numerator is adjusted as if the dividends and interest on the convertible had never been recognized.        
In the case of convertible bonds, this corresponds to the if-converted method of accounting. In the case of outstanding call options on a company's stock, the increase in the denominator is calculated based upon the treasury stock method, as the intrinsic value of the option divided by the current market share price. These accounting rules for calculating diluted EPS essentially classify hybrids as either earnings-reducing (debt) or share-increasing (equity), without any assessment of how likely it is that the hybrid behaves as one or the other. Although it is a calculable and unambiguous accounting quantity, it is clear that diluted EPS does not accurately represent the economics for existing shareholders, i.e., how much of a given period's earnings each existing shareholder is entitled to.
Consider, for example, the impact of issuing a convertible bond on existing shareholders. These shareholders realize that earnings from the current year are not entirely their own. If some of those earnings are retained, contracted future shareholders (e.g., convertible bond holders) will be entitled to a piece of the pie. Some complications arise in determining how much remains for each existing shareholder. First, in many cases, it is unclear whether the bond will ever be converted to equity. Second, even if it is eventually converted, the number of shares may be uncertain (it may be dependent, for example, on the share price). The if-converted method assumes that convertible bond holders will become shareholders regardless of the likelihood of such an event. This accounting method does not capture the expected increase in number of shares nor its uncertainty. Third, interest paid to convertible bond holders is no longer available to distribute to existing shareholders. It seems inaccurate, therefore, to add interest payments back into the numerator as required by the if-converted method. Fourth, and finally, equity dividends paid to existing shareholders are not shared with future shareholders. Only retained earnings are shared. If a company distributed all of its earnings to existing shareholders through dividends, then future shareholders would have no claim on the earnings and would therefore not dilute earnings per share. Equity dividend policy does matter (the initial pricing of the convertible bond issuance would, of course, reflect a company's dividend policy).
These flaws make diluted EPS a poor tool for making economically based decisions regarding hybrid securities. In order to capture the economic consequences of hybrids more accurately, it is necessary to depart from this accounting view and abandon diluted EPS in favor of the Economic EPS methodology of the present invention. Economic EPS is a better measure of existing shareholders' probable economics. Specifically, it recognizes that: (1) the interest paid to convertible bond holders reduces income available to existing shareholders; (2) the equity dividend policy affects the division of earnings between existing and future shareholders; and (3) the number of shares (denominator) is uncertain as well as the earnings themselves (numerator).
Of note, certain figures have legends with identification numerals associated therewith. These identification numerals correspond, of course, to various likewise labeled plot elements included in respective ones of the figures.
Among those benefits and improvements that have been disclosed, other objects and advantages of this invention will become apparent from the following description taken in conjunction with the accompanying figures. The figures constitute a part of this specification and include illustrative embodiments of the present invention and illustrate various objects and features thereof.